U.S. Tax Court Update

Notable 4th Quarter 2015 Cases, Part II of II

Part II of this article highlights the remaining notable 4^th Quarter 2015 U.S. Tax Court Cases that will be of interest to valuation practitioners and business advisors.  Estate of Purdue reminded us that taxpayers need to address 2036(a) concerns and establish a non-tax reason.  In addition, the case reminds us that gifting an equity or LLC interest may not qualify as a present interest for gift tax purposes.  Estate of Newberger involved the proper valuation of artwork, yet its holding is applicable to a business valuation opinion.  Sumner Redstone v. Commissioner involved a family succession saga and highlights the importance of filing a gift tax return since the statute of limitations is left open.  Readers should download the opinion to read about the valuation methodology employed and court’s critique of the expert’s report.  While DNA Pro Ventures, Inc. ESOP serves to stress the importance of following plan language and obtaining qualified appraisals in connection with ESOPs.  Finally, Kardash v. Commissioner, involves a highly unusual Rule 161 motion where the U.S. Tax Court addresses insolvency and fraudulent transfers.  This latter case is a decision that QuickRead covered in 2015. That 2015 QuickRead article focused on how the expert established when the company became insolvent.  We again have included excerpts here where the U.S. Tax Court discusses its views on what is a valuation.

Read Part I here.

DNA Pro Ventures, Inc. Employee Stock Ownership Plan v. Commissioner, T.C. Memo. 2015-195 (October 5, 2015)

Issues: Whether the Service’s final nonqualification letter determining that for its plan year ending December 31, 2008, and its subsequent plan years, 2009 and 2010, the DNA Pro Ventures, Inc. ESOP was not qualified under section 401(a0 and that the related trust was not exempt from taxation under section 501(a).

Whether the Service abused its discretion in its determination.

Facts: Dr. Prohaska, an orthopedic and sports medicine doctor, and his spouse created DNA Pro Ventures, Inc. (DNA) in November 2008.  He and his spouse became DNA directors.  DNA created an ESOP when it was founded.

During 2008 DNA did not pay any salaries, wages, or other officer’s compensation.  For 2009 DNA issued separate W-2s to Dr. and Mrs. Prohaska reporting the respective amount of $4,500.  DNA issued W-2s for 2010 to the two founders reporting $3,000 respectively.

DNA deducted a $1,350 retirement plan contribution of its Form 1120 for 2009; DNA did not file any Forms 5500 for plan years 2008 to 2010.

In 2012 the Revenue Agent issued Dr. Prohaska Form 886-A, Explanations of Items, determining that the ESOP was not qualified under section 401(a) for the plan years ending December 31, 2008, 2009, and 2010.  Any related trust was also determined not to be exempt from taxation under section 501(a) for the same trust years.

On June 6, 2014, respondent issued a final nonqualification letter, Letter 1757-A, to DNA explaining that the ESOP had failed to follow the terms set forth in the plan documents and therefore was not qualified under section 401(a) and the ESOP trust was not exempt from tax under section 501(a).

The nonqualification letter states, in part, as follows:

In this case, the ESOP had two separate failures to follow its plan document during 2008.  First, the ESOP sponsored by DNA Pro Ventures allowed Dr. Daniel J. Prohaska and Amy Prohaska to participate in the ESOP as of the plan year ending December 31, 2008, in violation of the terms of the ESOP plan document regarding eligibility and participation.  Second, the ESOP plan document required the ESOP to use appraisal rules substantially similar to those issued under I.R.C. sec. 170(a)(1) when it obtained annual appraisals for the same plan year.  The ESOP, however, failed to obtain any appraisal for the 2008 plan year, or for any plan year.

****

During 2008, DNA Pro Ventures, Inc. transferred stock into the ESOP without consideration, and the stock accrued to the benefit of Dr. Prohaska (50%) and Mrs. Prohaska (50%).  The value of the stock accruing to each participant, as reported by the ESOP, substantially exceeded 100% of each Dr. Prohaska’s and Mrs. Prohaska’s compensation from DNA Pro Ventures, Inc. for the year 2008.  Thus, the ESOP failed to comply with I.R.C. secs. 401(a)(16) and 415 for the plan year ending December 31, 2008, and is not a qualified plan within the meaning of I.R.C. sec. 401(a) for the plan year ending December 31, 2008 and all subsequent plan years.

Held:

1. The ESOP is not qualified and the trust is taxable.
   The Court observed that the failure to qualify under section 401(a) resulted from two issues.  The first was that, as explained below, the ESOP failed to satisfy the section 401(a) requirements in two separate ways, either of which is sufficient for the plan to not be qualified.  See secs. 401(a), 4975(e)(7).  Clearly, respondent has not abused his discretion.

Contribution Limits

Section 401(a)(16) provides that a trust is not qualified if the plan “provides for benefits or contributions which exceed the limitations of section 415.”  For the 2008 plan year, a participant’s annual additions were limited to the lesser of $40,000 or 100% of the participant’s compensation.  See sec. 415(c)(1).  Annual additions are the sum of employer contributions, employee contributions, and forfeitures.  See sec. 415(c)(2).  An allocation of stock to a participant’s account is an employer contribution.  See sec. 1.415(c)-1(b)(5), Income Tax Regs.  “Participant’s compensation” is “the compensation of the participant from the employer for the year.”  See sec. 415(c)(3)(A).  A plan that allows contributions that exceed the contribution limits of section 415 is not a qualified plan under section 401(a).  See, e.g., Van Roekel Farms, Inc. v. Commissioner, T.C. Memo. 2000-171, aff’d, 12F. App 439 (8th Cir. 2001).

In addition, a section 415 failure is a continuing failure that disqualifies the plan for a future year even when there is not a separate, independent section 415 failure in the future year.  Martin Fireproofing Profit-Sharing Plan & Tr. v. Commissioner, 92 T.C. at 1184-1185.

Neither Dr. Prohaska nor Mrs. Prohaska received any compensation for his or her services as a DNA officer or employee during 2008.  Accordingly, their contribution limits were zero.  Because DNA improperly transferred to Dr. Prohaska’s ESOP account 1,150 shares of DNA’s class B common stock in 2008 (with a $10 par value per share), the annual addition to his account was $11,500 more than his contribution limit under section 415(c).  Accordingly, because Dr. Prohaska’s ESOP account received an annual addition in excess of the section 415(c) limitation, the ESOP failed the requirements of section 401(a)(16) and was not a qualified plan for 2008.  Moreover, because the section 415 failure is a continuing failure, the ESOP failed section 401(a)(16) for 2008 and was not a section 401(a) qualified plan for all subsequent plan years.

The second problem with the ESOP is that petitioner’s failed to submit qualified business valuations for the ESOP.

2. The Service did not abuse its discretion.

In this declaratory judgment proceeding, we review respondent’s determination that the plan was not qualified.  The standard for our review was enunciated in Buzzetta Constr. Corp. v. Commissioner, 92 T.C. 641, 648 (1989), as follows:

When reviewing discretionary administrative acts, however, this Court may not substitute its judgment for that of the Commissioner.  The exercise of discretionary power will not be disturbed unless the Commissioner has abused his discretion, i.e., his determination is unreasonable, arbitrary, or capricious.  Whether the Commissioner has abused his discretion is a question of fact, and petitioner’s burden of proof of abuse of discretion is greater than that of the usual preponderance of the evidence.  Estate of Gardner v. Commissioner, 82 T.C. 989, 1000 (1984); Oakton Distributors, Inc. v. Commissioner, 73 T.C. 182, 188 (1979).

Further, “[i]n order for a plan to be qualified, both its terms and its operations must meet the statutory requirements.”  Id. at 646. Respondent’s determination is presumed to be correct, and the burden of proof is on petitioner.  See Rule 142(a).  To prevail, petitioner must prove that respondent abused his discretion.  See Buzzetta Constr. Corp. v. Commissioner, 92 T.C. at 648.  Petitioner has failed to do so.

 

Willian Kardash, Sr. Transferee v. Commissioner, T.C. Memo. 2015-197 (October 6, 2015)

Issues: Whether the U.S. Tax Court erred when it held, among other things, that respondent established that transfers to petitioner in 2005, 2006, and 2007 were fraudulent under Florida law and that petitioners were liable as transferees for those years under section 6901(a).

Facts: This opinion supplements the U.S. Tax Court’s prior opinion Kardash v. Commissioner, TC Memo.  2015-51.  The matter is before the U.S. Tax Court on petitioners’ motion for reconsideration under Rule 161 of the above opinion.

In motions pursuant to Rule 161, petitioners request the Court to address in this reconsideration two issues.  Specifically, petitioners raise two issues; (1) whether the earlier conclusion that Florida Engineered Construction Products, Corp. (FECP) was insolvent at the beginning of 2005 was a substantial error, and (2) whether payments in 2005, 2006, and 2007 were part of a deferred compensation plan.

Held:

While the Court found that the company was not insolvent in 2005, it still deemed transfers made petitioner as fraudulent.  It explained:

We rely largely on Dr. Shaked’s market multiple valuation to determine the solvency of FECP.  Although Dr. Shaked recommends the use of the asset accumulation value, we disagree.  The asset accumulation value does not take FECP’s intangibles into account.

We believe that FECP had some intangible assets with value and therefore rely on the market multiple valuation that values FECP as a going concern.  From Dr. Shaked’s market multiple valuation it is clear that FECP had a negative equity value of $12,308,515 on the transfer date, January 27, 2006, and it remained insolvent through March 23, 2007.  Thus, we modify our initial finding that FECP became insolvent in 2005, and instead find that FECP became insolvent starting January 27, 2006, and remained insolvent for 2006 and 2007.

Petitioners argue that we should reconsider our opinion to find them not liable for the 2005 transfers because FECP was solvent at the time of the transfers. Under Florida’s Uniform Fraudulent Transfer Act (FUFTA), a transfer is fraudulent if the debtor did not receive reasonably equivalent value and the debtor was insolvent at the time of the transfer or became insolvent as a result of the transfer.  Fla. Stat. Ann. sec. 726.106(1) (West 2012).  “Although the language of the UFTA [Uniform Fraudulent Transfer Act] speaks in terms of a single transfer of property, a series of transfers may also be found to be fraudulent.”  Berland v. Mussa (In re Mussa), 215 B.R. 158, 169 (Bankr. N.D. Ill. 1997).  Further, we have held that insolvency may be measured after a series of related transfers which in total leave the transferor insolvent.  See Botz v. Helvering, 134 F.2d 538, 543 (8th Cir. 1943), aff’g 45 B.T.A. 970 (1941); see also Hagaman v. Commissioner, 100 T.C. 180 (1993); Gumm v. Commissioner, 93 T.C. 475, 480 (1989), aff’d without published opinion, 933 F.2d 1014 (9th Cir. 1991); Leach v. Commissioner, 21 T.C. 70, 75 (1953).

As discussed in Kardash v. Commissioner, at *28-*31, we held that the 2003 and 2004 transfers were for reasonably equivalent value and were different in nature from the transfers in 2005, 2006, and 2007.  Although we now find that FECP was solvent during 2005, the transfers were still constructively fraudulent because they were part of a series of transactions that led to the insolvency of FECP.  Therefore, we find that the transfers beginning in 2005 were fraudulent because the transfers were not for reasonably equivalent value and FECP became insolvent as a result of the series of transfers.

As for the second issue raised on reconsideration, regarding Mr. Kardash getting a credit for taxes paid on dividends reported, the Court stated:

Mr. Kardash alleges that he is entitled to credits against his transferee liability for taxes paid on transfers as reported dividends.  Mr. Kardash argues that the Government would receive an inequitable windfall if we refused to credit him with the amounts of tax he paid on the transferred amounts in [tax years] 2005, 2006, and 2007.  Reconsideration under Rule 161 is not the proper avenue; section 1341 is the appropriate remedy for Mr. Kardash in this situation.  See Delpit v. Commissioner, T.C. Memo. 1992-297 (citing Maynard Hosp., Inc. v. Commissioner, 54 T.C. 1675 [1970]).

Roberto Castro, Esq., MST, MBA, CVA, CPVA, CMEA, BCMHV is Technical Editor of QuickRead. Mr. Castro is a Washington State attorney with a focus on business, bankruptcy, exit and succession planning, Wills, Probate, Trusts, and Gun Trusts. He is a member of WealthCounsel and NACVA. Mr. Castro is also managing member of Central Washington Appraisal, Economic & Forensics, LLC and a business broker with Murphy Business. Mr. Castro can be contacted by calling (509) 679-3668 or by e-mail to rcastro@rcastrolaw.com or rcastro@cwa-appraisal.com.